2023-03-11 09:00:00 ET
Summary
- My REIT portfolio has materially outperformed over time.
- But I have at times also lost my money. My biggest loser cost me over 90% of invested capital.
- I share my lessons from this investment.
Overall, I have been quite successful as a real estate investment trust ("REIT") investor.
I have managed to earn roughly 2x higher total returns than the Vanguard Real Estate ETF ( VNQ ) and 4x higher returns than the MSCI US REIT Index.
I compare my performance to VNQ since it is the largest and most popular real estate exchange-traded fund ("ETF"), but it also includes real estate companies such as brokers, property managers, and other service providers, and for this reason, most active managers compare their performance to a REIT benchmark like the MSCI US REIT Index:
(Disclaimer: the inception date is 10/23/2018, which is when we launched our real-money portfolio at High Yield Landlord. Past performance is not indicative of future results.)
My biggest winners have been companies like VICI Properties Inc. ( VICI ), Essential Properties Realty Trust ( EPRT ), and American Campus Communities, which was recently bought out by Blackstone ( BX ).
But that does not mean that all my investments have been successful.
On the contrary, I have had my fair share of losers. I take risks to earn returns and sometimes, risk factors play out, and at other times, my analysis has been wrong and so I lost money because of my own mistakes.
My worst REIT investment of all time was a REIT called CBL & Associates Properties, Inc. ( CBL ). I still hold a position in it to this day because my preferred equity was converted into common equity after it was restructured in bankruptcy.
CBL Properties
Fortunately, it was among my smaller holdings because I lost over 90% of my invested capital.
So what went wrong and what can be learned from it?
The bull thesis was simple:
CBL was a typical cigar butt-type investment. It is a REIT that owned low-quality assets but it seemed so cheap that it caught my attention.
CBL is a mall REIT just like Simon Property Group ( SPG ), but unlike SPG which invests in Class A malls in primary markets, CBL is mainly invested in Class B malls in secondary markets.
Understandably, the market was worried about the future of CBL's properties.
Investors worried that its malls had no future in a world of same-day free shipping. Amazon.com, Inc. ( AMZN ) and others were rapidly gaining market share and CBL was feeling the pain.
As a result, the market priced CBL at a very high dividend yield of >10% and it was offered at what appeared to be a huge discount to its net asset value.
I thought that the risk-to-reward was compelling because:
- The payout ratio was low at around 50%, leaving ample cash flow to reinvest in upgrading the properties.
- The properties still generated growing sales per square foot, despite the headlines of the retail apocalypse.
- The malls were lower quality, but they were market-dominant in secondary markets, potentially protecting them from higher-quality malls, which could not be built in many of its markets.
- Its malls were rapidly evolving into mixed-use destinations with diversified uses and the redevelopment of Sears, JCPenney, Macy's ( M ), and other department stores offered an opportunity to capture an upside in rents since anchor tenants had historically enjoyed very low rents.
- Finally, its share price seemed low relative to historic valuations. We thought that as CBL continued to redevelop its malls, the narrative would eventually change, leading to a significant upside, and while we waited, we would earn a high yield.
CBL Properties
Yet, I almost lost it all.
What did I miss?
I made one major mistake:
I underestimated the company's leverage because I overlooked the impact of capex spending. I thought that the company's payout was safe because the dividend only represented about 50% of its FFO.
But adjusted for capex, the dividend was poorly covered and the leverage was excessive relative to its free cash flow.
The capex went into improving the malls and so it misled me into thinking that it was optional and could be reduced if needed.
But the reality is that these malls were struggling and if they stopped spending the capex, these malls could quickly end up in a death spiral.
The consequence of this is that CBL's balance sheet was too weak to endure the pandemic. The company had already cut its dividend and later it fully eliminated it, but even that wasn't enough as its tenants began to miss rent payments and it drove the company into bankruptcy.
What are the lessons here?
There are three main lessons:
Lesson #1: Capex should not be underappreciated. It has a major impact on leverage and financial flexibility. Not all capex is optional and in the case of malls, it was critical to their survival. The same applies today to office buildings today! We think that investors are commonly overlooking capex and as a result, they overestimate the free cash flow generation potential of discounted office REITs like SL Green ( SLG ) and Vornado Realty ( VNO ). They are priced at very low FFO multiples, but once you account for capex, the multiples aren't as low as they may seem.
Lesson #2: Leverage is always the killer in real estate. If you own decent assets and have average management, you likely won't lose money in the long run, UNLESS you use too much leverage. Charlie Munger famously said that smart people lose money because of the 3 Ls: Leverage, Liquor, and Ladies, or something like that. I learned the hard way that higher leverage does not always lead to higher returns.
Lesson #3: Payout ratios can be deceiving. Most REIT investors focus on payout ratios that are based on FFO. They don't account for capex and so naturally, they will typically overstate the coverage, often by a wide margin. This is the case for many office REITs today and this is why I expect many more cuts in the coming years.
Bottom Line
CBL was my biggest loser but also one of my biggest lessons. It allowed me to avoid all the office REITs, which seemed undervalued in early 2022, but they then dropped by over 50% since then:
So in a sense, I am glad that I suffered the losses on CBL. Back then, my investment portfolio was a lot smaller and so I didn't lose nearly as much as I would have if I had invested in office REITs.
What's your worst performer of all time?
And most importantly, what lessons did you learn from it?
Share with us in the comment section below.
For further details see:
My Worst REIT Investment Of All Time